Today I will continue my indicator series of posts (which had been a little bit neglected) with a post about the stochastic oscillator which is one of the most popular indicators out there which, by the way, is traded the wrong way in many cases. In order to understand how to trade with the stochastic indicators, what trading systems would benefit from it and which won't, we first need to take a look at the math that defines the stochastic oscillator.
The stochastic oscillator introduced by George lane, simply calculates where price stands against the high and low of a previous amount of periods. That is, you can consider the stochastic oscillator value of as a measure of on what percentage of the range between the low and high of a certain period you are located. The equation that calculates this is as follows:
As you can see, the stochastic oscillator varies between values of 0 and 100 and as I said, tells you where price is in relation to a certain period's high and low. What does this mean ? Well, it means several things. Depending on the market conditions, the stochastic oscillator behaves differently. When the market is ranging or trending within a channel, the stochastic oscillator will forecast oversold or overbought markets as values near the high of a range are prone to be sold and lows are prone be bought. When the market is trending, things change a little bit since highs are pushed further and further up (lows the opposite) so the oscillator remains at high levels (low levels for down trending markets) all the time and people who are trying to treat that like an overbought or oversold market get killed because they are trading against the trend.
Since we would like to catch trend, which are the most juicy opportunities in the forex market we should only trade the stochastics when they are overbrought or oversold that is, we must follow the reverse of the "traditional" stochastic interpretation. Of course, if you do this and the market ranges, you are always trying to get into a trend that just reverses because the market fails to breakout.
The stochastics has the advantage also of being a leading indicator since it gives signals before the trends actually start. So if you trade the stochastic oscillator with a reversed type logic and a trend following indicator, you might be able to get yourself a profitable system. Although, there might also be the need for the inclusion of volatility type filter and some other creative use of trend following indicators (more on this later !).
All this information about the stochastic oscillator really lets you see how you must know the mathematical basis of an indicator and it's true meaning in order to use it effectively in the forex market. As you can see, a traditional interpretation of the stochastics with a trending indicator makes no sense as they constantly contradict each other and you can hope for a breakeven system at best. Stay tuned for the next post on the indicator series which will focus on the MACD, another very popular forex indicator.
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